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In Figure 18.2 fixed operating expenses are inflated by $480,000 (from $2,300,000 to $2,780,000). This amount is shifted from fixed manufacturing overhead costs, which decreases from $2,100,000 to $1,620,000. Thus, $480,000 in manufacturing fixed overhead escapes being charged to the 12,000 units produced, which decreases unit product cost by $40, from $685 to $645.

Remember that 1,000 of the 12,000 units manufactured during the year go into ending inventory, not out the door to customers. Each of the 1,000 units carries $40 less in fixed overhead cost, for a total of $40,000 less in ending inventory.

Operating profit, or taxable income before interest, is $40,000

less as the result of the misclassification error, so income tax for the year would be less. In one sense, we have cooked the books to record $40,000 less in operating profit simply by reclassifying some costs away from manufacturing.*

*Although it would be rather unusual, a manufacturer could start and end the period with no inventory, in which case profit would be the same no matter how costs were classified—although for internal management reports the proper classification of costs is always important.

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Management Profit Report for Year

Sales Volume = 11,000 Units

Per Unit

Total

Sales revenue

$1,400

$15,400,000

Cost-of-goods-sold expense

($ 645)

($ 7,095,000)

Gross margin

$ 755

$ 8,305,000

Variable operating expenses

($ 305)

($ 3,355,000)

Contribution margin

$ 450

$ 4,950,000

Fixed operating expenses

($ 2,780,000)

Operating profit (earnings before

interest and income tax)

$ 2,170,000

Manufacturing Costs for Year

Annual Production Capacity = 12,000 Units

Actual Output = 12,000 Units

Basic Cost Components

Per Unit

Total

Raw materials

$ 215

$ 2,580,000

Direct labor

$ 260

$ 3,120,000

Variable overhead

$

35

$

420,000

Fixed overhead

$ 135

$ 1,620,000

Total manufacturing costs

$ 645

$ 7,740,000

Distribution of Manufacturing Costs

11,000 units sold (see above)

$ 645

$ 7,095,000

1,000 units inventory increase

$ 645

$

645,000

Total manufacturing costs

$ 7,740,000

FIGURE 18.2
Misclassification of manufacturing costs.

Target sales prices may be determined by marking up unit product cost a certain percent. Thus, managers should be very clear regarding whether all manufacturing overhead costs are included in the calculation of unit product cost. If not, the markup percent should be adjusted since it would be based on an understated unit product cost. The better course of action would seem to be to properly classify all manufacturing overhead costs in the first place.

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IDLE PRODUCTION CAPACITY

Most manufacturers have fairly large fixed manufacturing overhead costs—depreciation of plant and equipment, salaries of a wide range of employees (from the vice president of production to janitors), fire insurance costs, property taxes, and literally hundreds of other costs. Fixed manufacturing overhead costs provide production capacity. Managers should measure or at least make their best estimate of the production capacity provided by their fixed manufacturing overhead costs. Capacity is the maximum potential production output for a period of time provided by the manufacturing facilities that are in place and ready for use.

Suppose the company’s annual production capacity were 15,000 units instead of the 12,000 units assumed in the preceding example. The business has correctly classified costs between manufacturing and other operating costs. All other profit and production factors are the same as before. The company manufactured only 12,000 units during the year. The 3,000-unit gap between actual output and production capacity is called
idle capacity.
In short, the company operated at 80

percent of its capacity (12,000 units actual output ÷ 15,000

units capacity = 80%). I should mention that 20 percent idle capacity is not unusual.

Producing below capacity in any one year does not necessarily mean that management should downsize its production facilities. Production capacity has a long-run planning horizon. Most manufacturers have some capacity in reserve to provide for growth and for unexpected surges in demands for its products. Our concern focuses on how to determine unit product cost given the 20 percent idle capacity.

In most situations, 20 percent idle capacity would be considered within the range of normal production output levels.

So the company would compute unit product cost the same as shown earlier. The 12,000-unit actual output is divided into the $2.1 million total fixed manufacturing overhead costs to get the fixed overhead cost
burden rate,
which is $175. This is the burden rate included in unit product cost in Figure 18.1.

The theory is that the actual number of units produced should absorb all fixed manufacturing overhead costs for the year even though a fraction of the total fixed manufacturing costs were wasted, as it were, because the company did not
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produce up to its full capacity. In this way, the cost of idle capacity is buried in the unit product cost, which would have been lower if the company had produced at its full capacity and thus spread its fixed manufacturing costs over 15,000

units.

The main alternative is to divide total fixed manufacturing overhead costs by capacity. This would give a fixed overhead cost burden rate of $140 ($2.1 million total fixed manufactur-

ing overhead costs ÷ 15,000 units annual capacity = $140 bur-

den rate). In terms of total dollars, the company had 20

percent idle capacity during the year, so 20 percent of its $2.1

million total fixed overhead costs, or $420,000, would be charged to an idle capacity expense for the year. This amount would bypass the unit product cost computation and go directly to expense for the year.*

Managers may not like treating idle capacity cost as a sepa-

rate expense because this draws attention to it. In the manufacturing costs summary, anyone could easily see that the business produced at only 80 percent of its capacity and so would be aware that the unit product cost is higher than if it were based on capacity.

If, on the other hand, actual output were substantially less than production capacity, the fixed overhead burden rate should not be based on actual output. The idle capacity cost definitely should be reported as a separate expense in the TEAMFLY

internal management profit report. (External financial reports seldom report the cost of idle capacity as a separate expense.) The generally accepted accounting rule is that the fixed manufacturing overhead burden rate included in the calcula-

tion of unit product cost should be based on a normal output level—not necessarily equal to 100 percent of production capacity, but typically in the 75 to 90 percent range. However, it must be admitted that there are no hard-and-fast guidelines on this. In short, some amount of normal idle capacity cost is

*Cost-of-goods-sold expense would be $7,150,000 (11,000 units sold × $650

unit product cost = $7,150,000); idle capacity expense would be $420,000.

The total of these two would be $7,570,000, which is $35,000 more than the $7,535,000 cost-of-goods-sold expense shown in Figure 18.1. In short, operating profit would be $35,000 less and ending inventory would be $35,000 less.

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M A N U F A C T U R I N G A C C O U N T I N G

loaded into the unit product cost because the fixed overhead burden rate is based on an output level less than full capacity.

MANUFACTURING INEFFICIENCIES

The ideal manufacturing scenario is one of maximum production efficiency—no wasted materials, no wasted labor, no excessive reworking of products that don’t pass inspection the first time through, no unnecessary power usage, and so on.

The goal is optimum efficiency and maximum productivity for all variable costs of manufacturing. The current buzz word is TQM, or
total quality management,
as the means to achieve these efficiencies and to maximize quality.

Management control reports should clearly highlight productivity ratios for each factor of the production process—each raw material item, each labor step, and each variable cost factor. One key productivity ratio, for instance, is
direct labor
hours per unit.
Ten to fifteen years ago it took 10 hours to make a ton of steel, but today it takes only about 4 hours; a recent article in the
New York Times
commented that the relatively low number of workers on the production floor of the modern steel plant is remarkable.

The computation of unit product cost is based on the essential premise that the manufacturing process is reasonably efficient, which means that productivity ratios for every cost factor are fairly close to what they should be. Managers should watch productivity ratios in their production control reports, and they should take quick action to deal with the problems. Occasionally, however, things spin out of control, and this causes an accounting problem regarding how to deal with gross inefficiencies.

To explain, suppose the company in the example had wasted raw materials during the year. Assume the $2,580,000 total cost of raw materials in the original scenario (see Figure 18.1) includes $660,000 of wastage. These materials were scrapped and not used in the final products. Inexperienced or untrained employees may have caused this. Or perhaps inferior-quality materials not up to the company’s normal quality control standards were used as a cost-cutting measure.

This problem should have been stopped before it

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amounted to so much; quicker action should have been taken. In any case, assume the problem persisted and the result was that raw materials costing $660,000 had to be thrown away and not used in the production process. The preferred approach is to remove the $660,000 from the computation of unit product cost, which would lower the unit product cost by $55 ($660,000 wasted raw materials cost ÷ 12,000 units output = $55). The $660,000 excess raw materials cost would be deducted as a onetime extraordinary expense, or loss, in the profit report.

The wasted raw materials costs could be included in unit product cost, but this could result in a seriously misleading cost figure. Nevertheless, exposing excess raw materials cost in a management profit report is a touchy issue. Would you want the blame for this laid at your doorstep? It might be better to bury the cost in unit product cost and let it flow against profit that way rather than as a naked item for other top-level managers to see in a report.

Standard Costs

Many manufacturing businesses use a standard cost system.

Perhaps the term
system
here is too broad. What is meant is that certain procedures are adopted by the business to establish performance benchmarks, then actual costs are compared against these standards to help managers carry out their control function.

Quantity and price standards for raw materials, direct labor, and variable overhead costs are established as yardsticks of performance, and any variances (deviations) from the standards are reported. Despite the clear advantages of standard cost systems, many manufacturers do not use any formal standard cost system. It takes a fair amount of time and cost to develop and to update standards.

If the standards are not correct and up-to-date, they can cause more harm than good. Nevertheless, actual costs should be compared against benchmarks of performance. If nothing else, current costs should be compared against past performance. Many trade associations collect and publish industry cost averages, which are helpful benchmarks for comparison.

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EXCESSIVE PRODUCTION

Please refer again to Figure 18.1. Notice that the $685 unit product cost includes $175 of fixed manufacturing overhead costs. If the units are sold, the fixed overhead cost ends up in the cost-of-goods-sold expense; if the units were not sold then $175 fixed overhead cost per unit is included in ending inventory. Inventory increased 1,000 units in this example, so ending inventory carries $175,000 of fixed overhead costs that will not be charged off to expense until the products are sold in a future period. The inclusion of fixed manufacturing overhead costs in inventory is called full-cost absorption. This sounds very reasonable, doesn’t it?

Growing businesses need enough production capacity for the sales made during the year and to increase inventory in anticipation of higher sales next year. However, sometimes a manufacturer makes too many products and production output rises far above sales volume for the period, causing a large increase in inventory—much more than what would be needed for next year.

Suppose, for example, that the company had sold only 6,000 units during the year even though it manufactured 12,000 units. Figure 18.3 presents the profit and manufacturing cost report for this disaster scenario. Notice that the company’s inventory would have increased by 6,000 units—as many units as it sold during the year!

The inventory buildup could be in anticipation of a long strike looming in the near future, which will shut down production for several months. Or perhaps the company predicts serious shortages of raw materials during the next several months. There could be any number of such legitimate reasons for a large inventory buildup. But assume not.